Leased buildings who pays the price for net zero

The size of the challenge is clear. An estimated 80% of the commercial buildings that will be here in 2050 already exist today, and most of these are currently sub-standard in terms of energy efficiency performance. As highlighted in our article 'Prioritising sustainability in the real estate sector', the challenge is not only working out what needs to be done, but also who is going to do what and who will pay.

There are a number of complex relationships which influence the debate. The majority of commercial space in the UK is leased so we have the landlord-tenant relationship to consider. Landlords want to maximise the recovery of their property holding costs from tenants and to protect their capital investment. In turn, tenants want to limit their occupation costs from capping service charge to limiting reinstatement/repair liability. In addition, there is often a third party with a vested interest in the property because the majority of leased space will also have a funder with security over the property.

Often, it is not clear where the obligation lies for who is responsible for making much-needed environmental performance improvement works in leases. Even where the liability between landlord and tenant is clear, commercial realities may drive different outcomes as to who will carry out the works and who will pay. Landlords are not the only ones driving the agenda – tenants also want to improve the energy efficiency of buildings that they occupy, and they are using as leverage the threat of exercising break clauses or not renewing leases.

Fortunately, practical initiatives emerged from COP26 which should help the real estate sector to focus efforts towards achieving net zero. On 11 November 2021 at the COP26 Built Environment day, the UK Green Building Council (UK GBC) launched its Net Zero Whole Life Carbon Roadmap for the Built Environment. This calls for a transformative shift in industry practices to help the UK meet its net zero commitment by 2050, and requires action across the industry. It recommended that both landlords and occupiers should urgently establish a net zero carbon strategy for the procurement and operation/occupation of commercial real estate. Stakeholder action plans include requirements on landlords to set building energy efficiency targets, formulate plans to transition away from fossil fuel heating, and ensure data sharing/transparency. Tenants are required to take ownership for the elements of energy usage that they can control, set clear reduction targets with a focus on the energy performance of fit outs, and collaborate with their landlords on fit out projects, low carbon heating and data sharing.

In the context of the call for action, the first question we are often asked is regarding existing commercial spaces is who carries liability for the cost of carrying out works to improve energy efficiency under existing leases.

Where the works could fall within the tenant's repairing obligations, then a landlord will need to consider whether they can require the tenant to do those works during the term of the lease, and ultimately whether the landlord can do the works themselves and recover the cost from the tenant.

Tenants may argue that the works go beyond repair and so fall outside of the scope of their obligation. The landlord may be unable to require the tenant to do the works, and may be unable to do the works themselves while the lease continues.

At lease expiry, tenants may be able to defend dilapidations claims on the basis that the value of an energy inefficient building will be so low, that there is no, or very little difference between the value of that property in and out of repair, significantly reducing the tenant's liability for damages at the end of the term.

The landlord may have the right to carry out the works but will need to consider whether they can recover the costs through the service charge. In multi-let premises, the question of liability for works, rights of access and recovery of costs are even more complicated.

Even where a landlord has the right to carry out works and has the ability to recover the cost from their tenant through the service charge provisions, then landlords will need to consider the impact of their works on tenants who are still in occupation. Tenants may claim compensation if they consider that their business and/or occupation has been disrupted by the works. Landlords may need tenants to move around the building to facilitate the works and will need to check whether their leases enable them to require the tenants to relocate.

Where landlords choose to carry out the works during a void period, this will necessarily lead to extra costs both in terms of funding the works, meeting ongoing service charge and insurance liabilities and lost revenue.

For new lettings, where tenants accept responsibility for additional costs to facilitate environmental improvements, this may depress rents. There is also a risk that environmentally-inefficient buildings will become stranded assets and that their capital value will deflate. Although many of our heritage buildings have long been considered trophy assets, the market's perception of a trophy asset may change, especially where tenants are drawn to buildings that support or enhance their carbon commitments. However, heritage buildings can compete on environmental performance if the right energy efficiency measures are introduced. Grosvenor, for example, is leading the way in reducing emissions from its historic estate by setting ambitious emissions reduction targets and committing investment in high impact retrofit projects, including the replacement of boilers and switching to LED lighting.

A central theme of the Whole Life Carbon Roadmap action plans is adopting a collaborative approach between landlords and tenants. ‘Green Leases’ are a good example of where much greater collaboration is needed. They have been talked about for many years but in reality we still do not have a settled 'market' position for either existing leases or how to draft new leases. The balance of liabilities between landlords and tenants have been established in commercial leasing practice over many decades, but environmental performance and environmental improvements are a relatively new concern and the market has not yet set a satisfactory standard for the split of these costs. This will need to change, and we are seeing a growing interest in adopting green lease clauses and anticipate that stakeholders will pick up the pace in 2022.

Ultimately, for effective action on climate change and ambitious carbon neutrality targets to be met, green provisions need to become so embedded in the real estate sector that they are an accepted market standard for every commercial property.

Ashurst are working with industry bodies, tenants, landlords and funders to:

• agree "best in class" green leases including repair and improvement clauses that are designed to cover sustainable and circular economy principles;
• advise on the structure of development agreements to ensure clear responsibility for ensuring that new and refurbished buildings achieve required MEES standards;
• devise business plans and risk mitigation strategies to facilitate energy efficiency works;
• develop innovative solutions for meeting the capital cost of those works; and
• take informed decisions to address assets which may become stranded.

The real estate sector’s net zero agenda is not being driven solely by the concerns about depressing values. There are also positive steps being taken to improve the built environment in which we live and work, which will create buildings that demand a 'Greenium' as well as contribute to wider environmental and social benefits.

As Her Majesty said when opening COP26, the “time for words has now moved to the time for action”. For those in the real estate sector wondering where to start or where to go from here, we would suggest looking at the UK GBC's Whole Life Carbon Roadmap action plans.